BBC406 Fundamentals of

Finance
Week 5 Analysis of Financial Statements

Learning Objectives
At the end of this chapter, you
should be able to:
Explain the purpose and importance
of financial analysis
Calculate and use a comprehensive
set of measurements to evaluate a
firms performance
Describe the limitations of financial
ratio analysis

Introduction
Knowledge of financial statements and the techniques in
analysing financial statements is desirable towards enabling
one to make optimal financial decisions that can have future
impact on the actions and direction of a firm.
However, some form of restatement, computations and
analysis may be required before information may be obtained
from the financial statements.

Financial Statements
A complete set of financial statements
includes:
Income Statement
Balance Sheet
Statement of changes in equity
Cash Flow Statement
Notes to Financial Statement

Financial Statements are prepared for a certain

period of time (Accounting Period) which
normally equals to 12 months.

Financial Statements
Just like a doctor takes a look at a patients xrays or cat-scan when diagnosing health
problems, a manager or analyst can take a look
at a firms primary financial statements i. e. the
income statement and the balance sheet, when
trying to gauge the status or performance of a
firm.
Income statement: periodic recording of the
sources of revenue and expenses of a firm,
Balance sheet: provides a point in time snap
shot of the firms assets, liabilities and owners
equity.

Benchmarking
The financial statements constitute fairly complex
documents involving a whole bunch of numbers.
Absolute values
tell us something about the amount of assets,
liabilities, equity, revenues, expenses, and taxes of
a firm,
difficult to really gauge whats going on, primarily
because of size and maturity differences among
firms.
requires benchmarking against some standard.
One common method of benchmarking a is to
compare a firms current performance against that
of its own performance over a 3-5 year period
(trend analysis), by looking at the growth rate in
various key items such as sales, costs, and profits.

Benchmarking (continued)
Table 5.1 Cogswell Colas Abbreviated Income Statements
($ in thousands)

Benchmarking (continued)
Another useful way to make some sense out of this mess
of numbers, is to re-cast the income statement and the
balance sheet into common size statements, by expressing
each income statement item as a percent of sales and
each balance sheet item as a percent of total assets.

Benchmarking (continued)
Table 5.2

Benchmarking (continued)
Table 5.3

Benchmarking (continued)
Benchmarking is a good starting point to
detect trends (if any) in a firms performance
and to make quick comparisons of key financial
statement values with competitors on a
relative basis.

More in-depth diagnosis requires individual

item analyses and comparisons which are best
done by conducting ratio analysis.

Income Statement
Measuring the financial performance of the
company.
Prepared to find out the Net Profit (Income >
Expenditure) or Net Loss (Expenditure >
Income) of the business after taking intro
account all expense for that accounting year.

Income Statement
Sales = CoGS +
Gross Margin

COGS

Gross
Margin

Sales
Revenue

Balance Sheet
Measuring the Financial position of the
company
Statement of capital/owner equity, liabilities
and assets of a business at a particular point of
time.

Balance Sheet
Assets = Equity +
Liability

Equity

Liability

Assets

Cash Flow Statement

Assessing the liquidity, solvency, and financial
flexibility
Free cash Flow to the firm: Amount of cash
available to both debt and equity holders
Operating Cash Flow
PLUS: Interest Paid Times (1-tax rate)
LESS: Investment in Fixed Capital____
______Free Cash Flow to the Firm____

Cash Flow Statement

Free Cash Flow to Equity: amount of cash
available to equity holders only
Operating cash flow
LESS: Investments in Fixed Capital
PLUS: New Debt Borrowing
LESS: Debt Repayment__________
______Free Cash Flow to Equity___

Financial Analysis and

Financial Ratios
Financial analysis is the use of financial statements to
analyse a firms financial position and its performance.
Questions:
Does a firm have the resources to succeed and grow?
Does it have adequate resources to invest in new projects?
What are its sources of profitability?
Did the earnings of the firm meet its forecast earnings?
What are the sources of a firms future earnings power?

Benefits of Ratios
Helpful in Decision Making
Helpful in Financial Forecasting and Planning
Helpful in Communication
Helpful in Co-ordination
Helps in Control
Helpful for Shareholders decisions
Helpful for Creditors decisions

Financial Ratios
Financial ratio analysis employs relative
rather than absolute concepts.
Financial ratios help readers to identify the
financial strengths and weaknesses of a
firm.
Financial ratios are classified into:
Profitability ratios
Liquidity ratios
Leverage ratios
Efficiency ratios
Market ratios

Recommended Steps
a) Establishing the objective(s) of the
analysis
b) Accumulating the necessary data from
the financial statements
c) Performing computations
d) Summarising and interpreting data
e) Reaching the conclusions

Financial Ratios
(continued)
5 key areas of a firms performance can be analyzed using financial
ratios:
1.

Profitability ratios: How well has the company performed overall?

2.

Liquidity ratios: Can the company meet its obligations over the short
term?

3.

Leverage ratios: Can the company meet its obligations over the long
term?

4.

Efficiency ratios: How efficiently is the company managing its assets to

generate sales?

5.

Market value ratios: How does the market (investors) view the
companys financial prospects?

Can also conduct a Du Pont analysis which involves a breakdown of the return
on equity into its three components, i.e. profit margin, turnover, and leverage.

Minion Bhd

Minion Bhd (cont.)

Profitability Ratios
Analyses the ability of management to generate adequate
profits from use of firms capital and assets.
Gross profit margin
Operating profit margin
Net profit margin (before or after tax)

Profitability Ratios (cont.)

Gross profit

Gross profit margin =

Revenue

100%

Gross profit margin measures how much a firm earns

from its revenue less the cost of goods sold
Gross profit margin =911,000

3,393,000

100%= 26.85%

For every RM1 of revenue earned by the firm, its cost

of sales amounts to RM0.7315. Minion Bhd has earned
sufficient revenue to more than cover the cost of sales,
hence the positive gross profit margin, i.e. RM0.2685
of gross profits for every RM1 of revenue made by firm.

Profitability Ratios (cont.)

income
Operating profit marginOperating
=
Revenue

100%

Operating income = Revenue Cost of goods sold

Selling, general and administrative expenses
Depreciation

272,000
100% = 8.02%
Operating profit margin3,393,000
=
For every RM1 of revenue earned by the firm, the
revenue is enough to cover up to RM0.9198 of the
firms total operating expenses. Management has
been able to manage the forces that influence the
amount of operating income that a firm earns.

Profitability Ratios (cont.)

before tax
Net profit margin Profit
=
100%
Revenue
245,000
Net profit margin =
100% = 7.22%
3,393,000
or
after tax
Net profit margin Profit
=
100%
Revenue
Net profit margin 171,000
=
100% = 5.04%
3,393,000

Liquidity Ratios
Measures the extent to which a firm has
adequate cash flows or liquid assets to
meet the short-term liabilities of the
firm:
- Current ratio
- Acid Test Ratio (Quick Ratio)
- Stock Turnover Ratio
- Debtors Turnover Ratio
- Creditors Turnover Ratio

Current Ratio and Acid Test

Ratio (Quick Ratio)
Current assets
Current ratio =
Current liabilities
This ratio indicates the extent of a firms liquidity, as
measured by the firms liquid assets (current assets)
relative to its liquid liabilities (current liabilities).

Current assets-stock
Acid test ratio =

Current liabilities

A more stringent version of liquidity ratio

Acid test ratio measures the ratio of current assets (less
stock) to current liabilities.

Current Ratio and Acid Test

Ratio (Quick Ratio) (cont.)
Current ratio = 1,182,000

= 1.61 times

736,000

1,182,000 - 435,000
Acid test ratio =
1.01 times
736,000

Stock Turnover Ratio

Stock turnover ratio =

Cost of goods sold

stocks

2,483,000
= 5.7 times
435,000
Stocks
Stock turnover days = Cost of goods sold= 365 days
Stock turnover ratio =

435,000
X 365
Stock turnover days =
2,482,000

= 63.97 days

Indicates the relative liquidity of stocks in a firm

Debtors Turnover Ratio

Indicates how long it takes for a firm to collect its
receivables
Debtors turnover ratio =Credit sales
Trade debtors
3,393,000
Debtors turnover ratio =
441,000

= 7.7 times

Trade debtors X 365 days

Debtors turnover days =
Credit sales
Debtors turnover days =441,000
X 365
3,393,000
days

= 47.44

Creditors Turnover Ratio

Indication of the extent of how quick the cash
outflows are in a firm
Credit purchases
Creditors turnover ratio =
Trade creditors
2,482,000
Creditors turnover ratio =
321,000

= 7.7 times

Creditors turnover days =Trade creditors X 365 days

Credit purchases
Creditors turnover days =321,000 X 365
2,482,000
47.20 days

Leverage Ratios
Investigate how a firm is being financed and provide
indicators as to the extent a firm is able to meet the
interest payments

Questions:
What is the relative ratio between the use of debt
versus equity to finance a firms assets?
Has the firm used too much debt?
Is the firm earning sufficiently to meet the interest
liabilities?
Debt ratio
Interest cover ratio

Debt Ratio
Debt ratio =
Debt ratio =

Trade liabilities
Total assets
883,000 + 736,000

= 0.5617 or 56.17%

1,700,000 + 1,182,000

Indicates that slightly more than 50% of the firms total

assets is financed using debt (long and short term debt)

Debt ratio =
Debt ratio =

Total long term borrowings

Total equity
707,000
1,263,000

= 0.5598 or 55.98%

Interest Cover Ratio

Earnings
Interest cover ratio =

before interest and tax

Interest expense

320,000
Interest cover ratio =
75,000

= 4.3 times

Firm has earnings before interest and tax that currently covers
up to 4.3 times its existing interest expense.

Firm may still be able to take on further borrowings

Efficiency Ratios
Efficiency ratios measure the extent to
which a firm is able to earn sufficient
earnings and returns to its investors.
Earnings per share (EPS)
Return on capital employed (ROCE)
Return on assets (RoA)
Return on equity (RoE)

Earnings Per Share

Earnings per share =

Earnings attributable to ordinary shareholders

Number of ordinary shares in issue

151,000
X 100
100,000

Earnings per share =

X 100 cents

= 151 cents

For every one ordinary share held by shareholders, Minion Bhd has
earned 151 cents of income, which may be either distributed to
ordinary shareholders as dividends or be kept in the firm as retained
earnings, but still belong to the ordinary shareholders.

Return on Capital Employed

(ROCE)
Return on capital employed =

Earnings before interest and tax (EBIT)

X 100%
Capital employed
Where capital employed = Long term debt + Equity
Return on capital employed = 320,000
X 100

1,970,000

= 16.24%

Assessment of the level of efficiency of the management of

Minion Bhd:
For every RM1 of funding provided to the management of
Minion Bhd, the firm is able to earn a return of RM0.1624
annually on average.

Return on Assets (RoA)

Return on assets =Profit after tax X 100%

Total assets

Total assets = Non current assets + Current assets

Return on assets = 171,000

2,882,000

100 = 5.93%

Assessment of the level of efficiency of the management

of Minion Bhd:

For every RM1 of assets that is made available to the firm

or that the firm invests in, the management of Minion Bhd
is able to generate a return after tax of RM0.0593.

Return on Equity (RoE)

Profit after tax
X 100%
Total shareholders' equity

Return on equity =

Return on ordinary equity =

Earnings attributable to ordinary shareholders

X 100%
Total shareholders' equity-Preference shares
171,000
X 100%
1,263,000

Return on equity =

Return on ordinary equity =

151,000
X 100% = 12.43%
1,263,000-48,000

= 13.54%

Market Ratios
Market ratios are ratios that are
based on the market price of a
firms share
Price earnings ratio (P/E)
Market-to-book ratio

Price Earnings Ratio (P/E)

P/E ratio =

Profit share
Earnings per share

1350
P/E ratio =
151

= 8.94

Minion Bhds shares currently sell for 8.94 times

its earnings.
Generally, firms with high P/E ratios are generally
taken as firms with bright future prospects.

Market-to-Book Ratio
Profit per share
Book value per share

Market-to-book ratio =

Book value per share = 1,263,000 -

48,000
100,000

Market-to-book ratio =13.50

= 12.15

= 1.11

12.15
Market-to-book ratio compares the market price of a
firms shares relative to the historical cost of the shares.

DuPont Analysis
Using the Decomposed Formula
Basic formula is Return on assets =
Profit after tax
Sales

Sales
Total assets

Total assets
Return on equity =
(Return on assets) X Equity
=

Profit tax
Total assets
Sales
X
X
Sales
Total assets
Equity

Du Pont Analysis

Time Series Analysis

Comparison between the firms current year

ratios with the same ratios of the
corresponding previous years
Ascertain whether the firms situation has:
1.
2.
3.

Improved
Worsened
Stayed the same

between one year and the subsequent

year(s).

Time Series Analysis

(cont.)

Suppose Minion Bhds current ratio for the

last five years were as follows:
Year

Current ratio

2005

5.32

2006

3.20

2007

2.56

2008

1.98

2009

1.61

Cross-sectional Analysis
Comparisons between the firms results and
the results of:
a) Other firms in the same industry
b) Other firms in other industries

Limitations of Ratios
Difficulties in identifying suitable industry
category to classify a firmfirm may be involved
in many different activities (how to identify similar
firms?)
Effects of inflation ignorecan distort figures
Accounting practices may differ between firms,
complicating comparisons of results between firms
Results may be distorted if there exist changes in
accounting standards, resulting in changes in the
presentation of financial results

Limitations of Ratios (cont.)

Firms may experience seasonality in their
performance.
An industry average may not be the desired
target or the norm, since industry averages
represent averages that includes the results of
both good and bad performing firms. Hence, one
should seek to compare against the best in the
class.
Progress of firm needs to be set in the context of
what other firms have done, and whether there
exist exceptional or special circumstances or
environmental or economic influences that
impact firms performances.

Limitations of Ratio
Limited Use of Single Ratio
Lack of Adequate Standards
Inherent Limitation of Financial Accounting
Changes of Accounting Procedures
Window Dressing
Personal Bias
Matchless
Price Level Changes
Ratios are not Substitute of Financial Statements
Wrong Interpretation